US Treasury Market is Headed Toward Rapid Growth in Trading Volume, Attracting New Dealers, Arbitrageurs and Trading Venues

Competition in the US Treasury market has been sparse with the number of primary dealers on the decline since the mid-1980s, but according to TABB Group in a new research note written by Adam Sussman, their director of research, new entrants are beginning to emerge. Although BrokerTec and eSpeed own the on-the-run interdealer broker (IDB) business and Bloomberg and Tradeweb dominate institutional dealer-to-client trading, TABB says “the combination of record issuance, expected rate hikes and a weakened competitive landscape make US Treasuries a ripe opportunity for mid-tier dealers, independent trading firms and hedge funds, alternative trading venues and the supporting technologies.”

“as they push into listed markets, and as interest rate swaps become centrally cleared, electronic treasury trading venues will become homogenized.”

“With interest in the U.S. Treasuries picking up – the U.S. Treasury issued more than $2 trillion in treasury securities in 2009, more than double that of 2008 and nearly three times more than 2007 – the market is headed toward a rapid growth in trading volume,” says Sussman. He adds that as the electronic venues continue their march down the path toward high-speed, streamlined matching engines, expanding into related markets to attract more high frequency and multi-dimensional arbitrageurs, “sparks are going to fly.”

In “On-The-Run Treasury Notes: The Benefits of a Tiered Market Structure,” TABB moves beyond a detailed description of the market structure for on-the-run U.S. Treasury notes, from the distribution of primary issuance to dealer-to-client platforms, then drills down into the recent history of the interdealer broker (IDB) platforms, detailing who is accessing those markets, how they access the market and what percentage of the market is attributable to non-dealers.

The 23-page report with 7 exhibits looks closely at how changes in matching logic are making the interdealer platforms look less like auctions and more like order-driven price/time markets, and examines how automation in banks' liquidity provisioning functions is affecting the liquidity discovery process on the dealer-to-client platforms.

With three main areas poised for change in the dealing cycle – dealer business models, interdealer brokerage and dealer-to-dealer (D2C) platforms – TABB believes the execution venues will remain segmented, but “there will be more fluid interaction between the three,” says Sussman. For IDB platforms, he explains “as they push into listed markets, and as interest rate swaps become centrally cleared, electronic treasury trading venues will become homogenized.” These trends will have as great an impact on Treasury markets structure as the 2004-2005 automation of Treasury futures contracts, when non-dealer volume on the IDB platforms nearly tripled in a year.

For D2C, the driver of change is the commoditization of connectivity, says Sussman. “While it used to be a feat of Herculean proportions to get enough sell-side and buy-side firms on board to create a viable marketplace, the industry is now sufficiently connected that even the most established markets could quickly lose market share. The transience of order flow will drive innovation, operational efficiency and cost reduction, particularly in a market with organic growth.”

Addressing the issue of market structure, Sussman says, “There are no Cassandras in the Treasury market because the regulators have a deeper understanding of liquidity formation, the market has appropriately segmented itself into separate venues and the mechanisms exist to balance the needs of all participants. The FRBNY and Treasury understand that not all traders play the same role in the market, and that it is perfectly okay for dealers, institutions and retail to have different rules and access mechanisms. The fact that some market-making function in the secondary markets has shifted to less regulated firms is not seen as a danger to other investors as long as the dealers interacting with clients still have fiduciary obligations. In fact, the equity markets have been headed in the same direction for quite some time.”